Chart Analysis – Top Formations Part 1

11/22/2007 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

The ability to recognize major top formations is, in some ways, more important than being able to identify major bottom formations. If you miss a major bottom formation it will generally mean a lost or delayed opportunity, but the consequences can be more severe when it comes to tops. If you have been holding a stock which has had a very nice upward move, it can be very demoralizing to give back much of your profits because of a failure to correctly identify a top. It is even worse if you end up buying a stock just before or as it is forming a significant top, as without proper risk management, you can wipe out a good part of your trading capital in a very short period of time. For those who are willing to “sell short,” major top formations can present some excellent profit-making opportunities. If you are not familiar with short selling, it is the practice of initiating a position by selling, instead of buying, and then, when the stock is lower, buying it back to close out the position at a profit. Of course, if the stock goes up, a short-seller buys it back at a loss. Though the risk in selling short is theoretically unlimited, you can decrease the chances of such a disaster by just selling short stocks that have already had significant rallies, and have then formed convincing tops.

Figure 1

There are several types of major top formations: head-and-shoulders tops, and rising wedges, as well as double and triple top formations. These formations seem to run in cycles; for a while, rising wedges will be prevalent, but then another formation will seem to be the most common. One top formation that has been seen less regularly in recent years is the head-and-shoulders (H&S) top. Fig. 1 shows a fairly classic H&S top formation and as you may notice, the chart does not have a label or a date axis. The reason for this will be explained later in the article. In order to start looking for a major reversal pattern, such as the H&S top, one has to be able to identify a prior trend. As you can see from this chart, the rise from the lows was indeed dramatic. The initial peak is labeled point 1, and the sharp correction gave back about 1/3 of its gains. Support was found at point 2, as once again this market turned higher and exceeded the prior peak by a significant margin (point 3). The market’s sharp decline from this peak, which ended at point 4, was the first sign or indication that the uptrend might be losing upside momentum. At this point, the chartist is able to make some interpretations. First of all, with support drawn at line A, point 1 can be tentatively labeled the left shoulder (LS), and the peak at point 3 can be seen as the head of the H&S top formation. With these conclusions, the support at line A becomes the neckline of the H&S top formation, and the key level to watch. The rally from the lows at point 4 failed to surpass the high at point 1 (LS) and was thus labeled as the right shoulder (RS). The break of the neckline (line A) came just nine weeks later at point B, as the market dropped very sharply.

Figure 2

So what market is shown in Fig. 2? It’s actually a chart of the Dow Industrials from 1915-1918. The reason for not labeling this originally is two-fold. First of all, I wanted to demonstrate that these chart formations have been in existence for quite a while, and secondly, I have noticed that an unlabeled chart can sometimes receive a more objective interpretation than a labeled one. One notable detail is that in this case, volume data, which plays a vital role in chart analysis, did not fit the ideal pattern. In a classic H&S top formation, volume should be highest as the left shoulder is being formed, then decrease as the head is formed, and be even lower on the right shoulder. The volume should then increase significantly as the neckline is broken. The chart labels indicate the ideal volume patterns. In this example, volume was heavier as the Dow rallied to form the head, but was also high, as the Dow turned lower. Volume was lower on the right shoulder but did not expand dramatically as the neckline was broken in August of 1917.

Figure 3

For a more recent example, let’s look at Interpublic Group (IPG), which formed a weekly head-and-shoulders top from 1999 until early 2002. As I am sure you have realized from the other articles in this series, rarely does a formation meet all the criteria that one might find in a textbook. As for IPG, the left shoulder (LS) formed in July, then, after pulling back to support in the $34-$36 area for several months, IPG again turned higher and reached $58.40 in December 1999. Volume at the head was about the same as that at the LS but as IPG declined to support at $32-$33 in October, volume did increase. Once again IPG was able to rebound and approached the $48 level, slightly exceeding the LS peak. At this point, there was enough evidence to raise the possibility that an H&S top was forming. As IPG turned lower, the increase in volume supported the bearish case. It would be several months later, in June 2001 (point 1), that the neckline would be convincingly broken. Because of the scaling, the volume levels are tough to assess, but it did show an increase on the break as noted by the rectangle labeled 2.

Once the neckline was broken, the trader was able to calculate a price objective by taking the distance from the head to the neckline (labeled a), which was $58.40-$33.60 or $24.80 and then subtracting this amount from the breakout point. This gives you a downside target of $32-$24.80 = $7.20 that was reached in February 2003. You should also note that after the neckline was broken, IPG dropped for four months before starting a six-month rebound. Often times, after a head-and-shoulder formation is completed, you will get a rebound back to the neckline, which is an ideal selling opportunity. In this case, the rebound went above the neckline level, but held below the resistance in the $40 area (dashed line), which was significant.

Figure 4

A more commonly observed top formation in the past few years has been the double top formation. In 2000-2001, Boeing (BA) completed a double top formation on the weekly charts. Two approximately equal peaks characterize the double top, where volume is highest on the first peak, and then lower on the second. The intervening low then becomes the key support level to watch. BA rallied from a low of $32 in 2000 to reach $70.93 in December 2000 (point 1). Over the next four months, BA eventually dropped back to a low of $49.70, line A, before again turning higher. Of course, one would not have drawn in this support level for several weeks until BA was again moving towards the previous highs. In May 2001, BA reached a high of $69.85 and closed the week strong. The next week however, BA reversed to close on its lows. This type of reversal, more easily visible in a candlestick chart, is not uncommon. Volume leading into point 1 was considerably more than was evident at point 2, as noted by the circled areas on the volume chart (see circles 1 and 2). The failure of the rally in July 2001 was an additional sign of weakness and presented the best opportunity to establish short positions prior to the break of support in early September 2001 (point 3).

To determine the price target from a double top, you measure the distance from the highest peak to the intervening low and then subtract this amount from the breakout point. As for BA, this gives you $70.93-$49.70 = $21.23 and if you subtract this from $49.70 you get a target of $49.70-$21.23 = $28.47. The actual low in September of 2001 was $27.60.

As always I welcome your feedback on these articles. I can be contacted at tomaspray@intershow.com. I would also appreciate any suggestions you may have for future articles.

Tom Aspray, professional trader and analyst, serves as video content editor for InterShow's moneyshow.com video network. Mr. Aspray joined InterShow full time in June of 2007 where he also does other editorial work for the site, including the bi-weekly trading lessons and the weekly charts to watch. Mr. Aspray has written widely on technical analysis and has given over 60 presentations around the world. Over the years, he has applied his methodologies not only to the stock and commodity markets but also the global markets, mutual funds, and foreign exchange. Many of the technical indicators that Mr. Aspray wrote about in the 1980s, such as the MACD, have since gained worldwide acceptance. He was originally trained as a biochemist but began using his computer expertise to analyze the financial markets in the early 80s. As a consultant, Mr. Aspray wrote daily institutional reports for firms such as Fleming Jardine and Barings Bank and was noted by the Wall Street Journal as one of the "top bond market technicians."

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